Sunday, 6 November 2011

Monetary systems - an introduction

Human beings require many goods and services for daily life - water, food, accommodation, clothing, healthcare and education are just a few examples. It might be theoretically possible for each individual to provide the goods and services they require for daily life by their own labour and resources, but this is massively inefficient in use of time and resources - let's consider the example of an individual who makes shoes for themselves only. A lot of effort is required to develop the skills and resources necessary to make the single pair of shoes, and the tools developed require storage space even when they are not in use. The same individual still needs to obtain other clothing, food and shelther, and it is unlikely that they will have the time and resources to specialise in all of these things. Clearly, this is not a particularly efficient way to do things.

The solution to this problem is for individuals to specialise in manufacturing or providing a larger quantity of specific goods or services, and to trade those goods or services for goods and services from others that the individual cannot provide themselves. This has the advantage of ensuring that each individual makes maximum use of their own skills and resources, but also has access to the products of the skills and resources of others also working efficiently in other areas of specialisation.

Mutual beneficiality
When people obtain goods or services under conditions free of duress or obligation, each party to the transaction (assuming the transaction is closed out with no ongoing obligations or debts) receives something that is of greater perceived value to them than what they have given up. This is the condition of mutual beneficiality. If this is not the case, then at least one party will not be willing to engage in the transaction, and no exchange will occur.

The previous paragraph implies that each party must place a different value on on at least one component of the exchange, otherwise mutual beneficiality cannot exist. This condition of differing relative values is a necessary condition for a trade to occur, assuming the absence of compulsion or threat! (Command economies, such as those in China after the Chinese Civil War and the ensuing Great Leap Forward of 1958-61 and Cultural Revolution of 1966-76, in Cambodia after Year Zero (1975 when Pol Pot seized power) or in the Soviet Union after the 1917 October Revolution, involved degrees of compulsion and threat!)

A requirement of any form of trade is that it must be percieved to be fair - the absence of fairness can lead to a refusal to trade or to conflict. Fairness is deeply wired into us, and even animals recognize and object to percieved unfairness in their treatment by others.

Ways of achieving provision of goods and services
For an society to use skills and resources efficiently and fairly, then, some form of free exchange of goods and services is essential. There are several arrangements that allow goods and services to be provided and obtained - or, alternatively, that facilitate economic activity. These include the household economy, the gift economy, the command economy, the barter economy, and the monetary token economy.

The household economy
A household economy is one where goods are not traded, but are instead produced and consumed by the same household. Given the small size of most households, this allows a limited degree of specialisation and efficiency, while also allowing individuals to benefit from the contributions of others in that household. If the expression "tribe" is substituted for "household", the same term might also describe hunter-gatherer societies, such as the Australian Aborigines, which were based on largely self sufficient small tribes (although trade of goods did occur between tribes). The desire for fairness will lead participants to attempt to ensure that everyone makes a "fair" contribution, to avoid other individuals free riding on the efforts of others.

The gift economy
A gift economy is well suited to small groups of people - such as small tribes of hunter gatherers, or, in contemporary Australian society, a group of schoolfriends who have regular contact with each other. In a gift economy, goods or services are freely gifted to other members of that small group. Although there may be no immediate reciprocation, since people in small groups remember who did or gave what to who, it is likely that a reciprocating gift of goods or services will occur later, and also that social standing within the group may be a partial function of one's gifting history. As a result, for each of the individuals within that small group, it is likely that they will value what they receive back from the group more than what they contribute, and they may receive goods or services that they cannot provide themselves - both beneficial characteristics of trade.

Gift economies are heavily dependent on trust, not suited to large groups of people, or to highly specialised or expensive goods and services. They are also unlikely to provide all the goods and services required by an individual - as the number of participants increases towards that required to provide all necessary services, it becomes impossible for individuals to keep track of the gifting history of everyone else in the group, so the shared knowledge and trust required to make the gift economy function are likely to break down. Consequently, a gift economy will only form a part of an economic system, at most.

The command economy
A command economy is one where people are ordered to provide goods and services to others or a greater social grouping, but generally without the condition of mutual beneficiality. This generally requires a degree of duress or compulsion. The major problem is that when mutual beneficiality does not exist, providers of goods and services attempt to reduce their losses by providing the cheapest and most limited goods and services possible, subject to the duress or compulsion applied. This then leads to reduced quality and quantity of goods and services - which was very clear in the Soviet Union under Communism.

The barter economy
A barter economy is based on the direct exchange of goods and services between willing parties, who each value what they receive more than what they give up in order to facilitate the trade. Barter economies are more suited to larger groups of people as they are not so dependent on awareness of a counter party's trading history to ensure fairness. While no society has ever relied fully on a barter economy, all economies have probably always contained a degree of barter. Bartering is well suited to exchanges of simple goods and services, such as foodstuffs, where exchanges can be easily set up with a small pool of available goods and services.

A limitation of barter economies is that one party may desire a good or service from the other, but may not be able to provide goods or services desired by the other party, particularly if the goods are highly specialised. For instance, if I am a banana grower, and wish to exchange some of my bananas for a memory expansion card for my notebook computer, this could be slightly difficult! A possible solution to this problem is to have "rings" of service or good provision involving 3 or more parties, rather than simple bilateral exchanges, but these are awkward to arrange so that either all transactions occur simultaneously in the same place, or so that all transactions are honoured when the individual service or good provisions occur at different times and places.

A second limitation is that some goods or services may not be naturally divisible on useful scales, so it may be difficult to ensure that the goods and services provided by each party to a transaction results in both parties percieving themselves to be better off. If I have a goat, which is worth roughly half a cow (remembering that perceptions of value by different parties will vary), and you have a cow, and we both want living livestock, the natural indivisibility of your cow means that unless I can find a second goat, I can't trade my whole goat for half of your cow.

A third limitation of barter is the lack of any general unit of value to aid relative valuations - if I want to obtain a writing pad and pen, and can supply sock darning services in exchange, it isn't particularly useful to know that a writing pad is worth roughly one three thousandth of a cow. A fourth limitation is the lack of ability to separate the exchange in time - for instance, for one party to supply two goats at the goat market today and then receive a cow at the cow market next month.

The limitations of household, gift, command and barter economies
As the range of goods and services available expands, as in any modern economy, a barter economy, or any economy based on a combination of the above forms of exchange, begins to run into significant problems. This because the number of suppliers of a good or service relative to the population size decreases as the degree of specialisation increases. As a result, it becomes increasingly difficult to achieve mutual beneficiality when a specific individual desires to obtain a specific good or service from another specific individual.

Montetary tokens
Most societies will include a combination of these forms of economy, where the circumstances exist to facilitate them. For the exchanges that cannot be facilitated using these techniques, another method of achieving mutual beneficiality is required. The universal solution to this problem has been to create a monetary token of exchange, or store of value, which is exchangeable for goods and services, and thus breaks the requirement for a bilateral exchange of goods or services as a prerequisite for economic activity.

These monetary tokens must have four characteristics:
1. They must be usable as a medium of exchange - that is, they must be exchangeable for goods and services, and they must be in universal acceptance. In other words, they must be "fiat" currency - currency which is declared to have value.
2. They must serve as a stable store of value - that is, they should maintain their value over a long period of time so that they can be used to conduct a series of transactions occurring over a period of weeks or months.
3. Any good or service must be able to be valued in terms of the monetary token, which also requires that the monetary tokens be divisible into sufficiently small quantities to cover most economic exchanges.
4. They must be of intrinsically low value, so that they are not destroyed and used for other purposes, such as coins with a metal value greater than the face value of the coin.

Fiat money in Australia
Fiat money is money which is generally accepted as having value. The way in which fiat money is conferred with value does not appear to be well understood. Let's start with an inspection of an Australian banknote. All Australian notes bear the inscription, "This Australian note is legal tender throughout Australia and its territories". Thus, the first characteristic, fiat currency status, is achieved by the agency of legal tender. The term "legal tender" does not mean that the note *can* be used as tender (indeed, in Australia, it appears that any object could concievably be used by two consenting parties as tender), but rather that, under Australian law, if one person owes another a debt of, say, ten dollars, and offers a ten dollar note in payment of that debt, the other person cannot refuse to accept that note in payment of that debt. This would apply if a debt is incurred by one party for goods or services already received, and then payment of that debt is offered later, such as if one eats dinner in a restaurant and then pays the bill afterwards.

There appear to be caveats, such that if payment in some other form was specified at the time the debt was incurred, then payment with legal tender may not be enforceable, and that payment in legal tender can be refused if the good or service is provided at the time of the prospective payment, so that no good or service has yet been provided, so that no debt yet exists (as when purchasing food at a takeaway shop). There are also rules relating to what amounts owing various denominations of currency are legal tender for - for instance, coins up to and including 50c are only legal tender for amounts owing up to $5, if they are the only coins offered. The Reserve Bank has a page on the subject, which clearly states the legal situation.

The universal acceptance of notes and coins is also assisted by the recycling of defaced and damaged notes and coins back to the Reserve Bank by the commercial banks, which are replaced by the Reserve Bank and returned to the commercial banks for general circulation. This helps to prevent the situation where merchants or customers refuse to accept damaged notes or coins in payment or change.

The second desirable characteristic of monetary tokens is achieved by government action to ensure that the supply of tokens amongst economic participants is kept stable, and also by enforcement action to prevent illegal counterfeiting of the physical tokens of exchange.

The third characteristic is achieved by setting the value of the currency so that the smallest denomination of currency is acceptably small to be used for minor transactions without complaint.

The fourth is achieved by manufacturing coins from cheap but durable metals, and notes from plastic. A plastic banknote has virtually no intrinsic value - it is too smooth to write on or blow one's nose with, too small to burn for heat, or to use to make anything of intrinsic economic value. The situation with coins is a little more complicated - metal is a useful resource, and coins could be melted down and used to make goods. By ensuring that the face value of the coin remains above the intrinsic value of the metal, this result can be prevented.

Australia's monetary tokens
In Australia, as in virtually all modern world economies, we have three main types of token, which are generally used and accepted as money. They are as follows:
1. Fiat money - consisting of physical notes and coins. These are a purely physical form of money.
2. Bank credit - either money that the bank owes us (deposit accounts) or money that we owe the bank (credit cards and mortgages). These credits only exist on the books of the commercial banks.
3. Reserves at the Reserve Bank of Australia, as accounts belonging to external parties. These reserves only exist on the books of the RBA.

Under benign economic conditions, account holders, commercial banks and the RBA are each able to perform specific exchanges of these monetary tokens. These tokens are defined by the exchanges that can be performed with them, and by the rules that apply to them. These exchanges will be the subject of the next post!

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About Me

I work as a digital signal processing (DSP) engineer, in the audio field. I have worked in structural, acoustic and mechanical services engineering, with a foray into grant administration with State Government. I have a double degree in engineering and science (more specifically civil and structural engineering, combined with physics and mathematics), followed by a Masters in electronic engineering. I also run (marathons and ultras), despite "retiring" (a relative term) in 2010. I'm a bit of a bike nut, and don't mind a bit of the cold white snowy stuff, when we're lucky enough to get some in Oz.